Three Different Approaches to Valuing A Business:
What does "Value" mean?
The true value of a business is simply the agreed amount a willing seller will accept and a willing buyer will pay. While the industry jargon, and multiple methods of assigning value can be confusing, there are three basic approaches used.
Three broad Valuation Approaches
Valuation is the generally accepted method of determining the value of a business for sale.
- Income approach- determines the value of a business based on its ability to generate desired economic benefit for the owners.
- Asset approach - determines the business value based on the value of its assets.
- Market approach - the business value is based on a comparison to historic sales involving similar businesses.
Business valuation methods for different circumstances
Which valuation method is used is dependent upon the business itself.
For example, a start-up business would have very little history, or financial trends to base the valuation on, so income valuation methods (such as the Discounted Cash Flow) might be used, relying on future business earnings (forecast and risk assessment), rather than actual past performance.
The value of business goodwill plays a significant role for businesses with long-standing history and reputation. The goodwill business business valuation method is oftentimes used in combination with other methods.
For businesses where similar companies sell often, a market business valuation method makes the most sense, and is the one we use most often at Transworld. These methods help determine a business' value by comparing the selling prices and financial performance of similar sold businesses, in the form of multiples (of EBITDA, SDE, EBIT).
Companies rich in tangible assets or real estate may benefit from using the asset accumulation business valuation method. This method helps determine the business purchase price to recover the initial investment and reduce taxes.
A Buyer's Perspective and Goodwill
Businesses are typically valued only after considering all three broad methods, but in the end, small businesses are most likely priced consistent with recent past sales of businesses with similar earnings (Market approach), based on what others have been willing to pay. So….what is the business worth to the buyer?
The question for buyers is, “What is the company goodwill and the ability to take over continuing operations worth?” While goodwill is by definition intangible, (that portion of the purchase price that is in excess of the business assets), we can still make assumptions of what that value is. A "going concern" value indicates the existence of business assets ready for use in producing business income.
Goodwill going concern values to consider:
- Position in the market place (customer base and relationships)
- Unique ability to serve customers
- Track record
- Operating procedures and training manuals
- Domain names / websites
- Product lines
- Trained employee workforce
- Management team
- Name recognition
- Vendor relationships
- Advertising programs
- Customer reviews and testimonials
- Franchise agreements
- Lease procurement and negotiations
- Telephone numbers
- Facility procurement
- Facility build out
What will it cost me to build the company from the ground up?
To quantify the value of goodwill, the buyer will have to consider the cost and effort of developing these assets from nothing, and add the lost opportunity cost (profits) of starting from zero, compared to hitting the ground running on day one with the intangible assets already in place. It’s easy to have an optimistic, flippant, low effort, and low cost perception of what goodwill is, but it is worth a buyer's time to research the true costs, risks, probability of success, and time requirements of starting a business, including:
- Likelihood of truly developing the same market base and how long will that take?
- Changing market costs
- Permitting / regulatory
- Site procurement
- Construction and / or lease buildout